Hedge Fund Strategies — Market Neutral

Market-neutral hedge funds are close to the true definition of a hedge fund, in that they “hedge” market risk with offsetting long and short positions.

A market-neutral hedge fund manager, for example, will take long positions in a company’s stock that he thinks is undervalued, and take short positions in stocks that he thinks are overvalued. The manager makes sure that the dollar value of the long position matches the dollar value of the short position, so that the total portfolio is neither net long or net short. If the long position outperforms the short position, the manager will earn the “performance spread” between the positions, plus any short-term interest earned on the proceeds of the short sale.

The basic idea behind market-neutral investing is to choose securities within a fairly homogeneous universe, balancing long versus short positions, so that the total portfolio is relatively unaffected by the overall movement of the market itself. The true driver of total return will be the manager’s skill at researching and selecting securities that he thinks will outperform the market. In theory, returns will not be affected by whether the underlying market goes up or down.

There are four major categories of market-neutral investing:

-Market-neutral equity: managers who buy stocks in what they perceive as undervalued companies, and sell short stocks in unattractive companies or an index of the market in which they are investing.

-Bond hedgers, who invest long and short in bonds;

-Convertible hedgers, who do the same using convertible securities, which are bonds or preferred shares that have an option to convert to common shares in the issuing company;

-Multi-strategy managers, who use a combination of the above strategies.

A good example of market-neutral equity investing comes from Robert A. Jaeger, in his book, All About Hedge Funds: The Easy Way to Get Started (McGraw Hill). He describes a strategy called “pairs trading.”

Suppose, for example, you thought Cisco Systems was undervalued in the market and had great potential. However, you felt that Cisco faced certain risks related to the market and economy in general or the technology sector, so you are reluctant to take an outright long position. A market neutral manager would take a long position in Cisco, offset by a short position in Microsoft. Therefore you are no longer betting that Cisco will simply go up. You are betting that Cisco will simply do better than Microsoft. Even if both companies’ stock fall in value, the trade will be profitable if Cisco declines less than Microsoft.

All market-neutral equity strategies depend on good security selection. But even then, there is no guarantee that if you buy a diversified portfolio of stocks and sell short a stock portfolio of equal size that you will automatically make money. Expectations and assumptions can be dead wrong. Stocks that appear to be undervalued can stay that way for a long time. Market-neutral equity investing is a very active form of investing and highly dependent on the skill of the portfolio manager to pick stocks that will outperform the portfolio of short positions.

According to Jaeger, the market-neutral investor is also an important source of liquidity for the markets. Market-neutral managers tend to be contrarian investors, buying on weakness and selling on strength. They add liquidity to the market for momentum investors who have the opposite trading pattern.

Next time, we’ll look at the other major subcategories of market-neutral investing: hedge fund jobs in bond and convertible securities hedging.